The Analysis of Financial Statements PART II

The Analysis of Financial Statements 1 Knowing the Business  The Products  The Knowledge Base  The Competition  The Regulatory constraints Strategy 2 Analyzing Information  In Financial Statements  Outside of Financial Statements 3 Forecasting Payoffs  Specifying Payoffs  Forecasting Payoffs 4 Convert Forecasts to a Valuation 5 Trading on the Valuation Outside Investor: Compare Value with Price to BUY, SELL or HOLD Inside Investor: Compare Value with Cost to ACCEPT or REJECT Strategy Chapter 7 How business activities are represented in financial statements Chapter 8 How the statement of shareholders’ equity is analyzed Chapter 9 Analyzing the balance sheet and income statement to reveal profitability Chapter 10 Analyzing the cash flow statement to identify cash generation Chapter 11 Analyzing profitability to discover what drives it Chapter 12 Analyzing residual earnings growth to discover what drives it

Chapter 7 Business Activities and Financial Statements

Business Activities and Financial Statements Chapter 1 introduced the firm’s operating, investing and financing activities. Chapter 2 introduced the financial statements. Chapters 5 and 6 outlined valuation models that anchor on those financial statements. Link to Previous Chapters This chapter shows how the three business activities are depicted in the financial statements. It also shows how the statements are redesigned to prepare the statements for applying the valuation models in Chapter 5 and 6. This Chapter Chapters 8, 9 and 10 reformulate statements according to the design developed in this chapter. Link to Next Three Chapters Link to Web Page How are the cash flows of a business identified in the cash flow statement ? How are operating and financing assets and liabilities identified in the balance sheet? How are operating and financing income identified in the income statement? What measures capture the operating and financing profitability ? to highlight these activities and Build your own analysis spreadsheet using BYOAP

What you will learn in this chapter How businesses are organized to generate value for shareholders The difference between operating and financing aspects of a business How business activities are reported in financial statements How financial statements are organized to highlight operating and financing activities How business activities articulate and how financial statements articulate The four cash flows of a business and how they relate to each other Why free cash flow does not affect value added A set of accounting relations that summarize how business activities drive financial statements

Cash Flows Between the Firm and Claimants in the Capital Market Cash received from debtholders and shareholders is (temporarily) invested in financial assets. Cash payments to debtholders and shareholders are made by liquidating financial assets (that is, selling debt). Net financing assets are debt purchased from issuers, net of debt issued to debtholders. Net financing assets can be negative (that is, debt sold to debtholders is greater than debt purchased). Key: F = net cash flow to debtholders and issuers d = net cash flow to shareholders NFA = net financial assets = financial assets – financial liabilities

Business Activities: All Cash Flows Cash generated from operations is invested in net financial assets (that is, it is used to buy financial assets or to reduce financial liabilities). Cash investment in operations is made by reducing net financial assets (that is, by liquidating financial assets or issuing financial obligations). Cash from operations and cash investment may be negative (such that, for example, cash can be generated by liquidating an operating asset and investing the proceeds in a financial asset). Key:F = net cash flow to debtholders and issuers d = net cash flow to shareholders C = cash flow from operations I = cash investment NFA = net financial assets NOA = net operating assets = operating assets – operating liabilities

The Cash Conservation Equation A fundamental accounting identity: C = Net cash from operations I = Net cash outflow for investing C - I = Free cash flow d = Net dividends (common dividends + share repurchases, less share issues) F = Net cash outflow to debtholders and debt issuers = Net principal payments for borrowing + net interest payments The treasurer’s rule: If : lend or buy down own debt If : borrow or reduce lending

Applying the Treasurer’s Rule: Microsoft In millions 2nd Quarter, nd Quarter, 2005 Cash flow from operations$4,236$3,377 Cash investment in operations Free cash flow 4,064 3,200 Cash interest received (after tax) Cash available for shareholders 4,402 3,442 Net dividend: Cash dividend $1,729 $33,498 Share repurchases Share issues (189) 2,270(795) 33,672 Purchase (sale) of financial assets$2,132 $(30,230)

Applying the Treasurer’s Rule: General Electric In millions 2002 Cash flow from operations$34,848 Cash investment in operations 61,227 Free cash flow (26,379) Interest paid (after tax) 6,082 Cash available to shareholders (32,461) Net dividend: Cash dividend $7,157 Share repurchases 985 8,142 Net issue of debt$40,603 As the treasurer had $57.8 billion of debt to repay, he issued $97.9billion of new debt, for a net debt issue of $40.1 billion.

Reformulated Statement of Cash Flows

Reformulated Cash Flow Statements: Microsoft In millions 1Q, Q, 2005 Cash flow from operations (C) $4,236 $3,377 Cash investment (I) (172) (177) Free cash flow (C – I) 4,064 3,200 Equity financing flows (d): Dividends and share repurchases $2,459 $34,467 Share issues (189) 2,270 (795) 33,672 Debt financing flows (F): Net purchase of financial assets 2,132(30,230) Interest on financial assets (after tax) (338) (242) Net issue of debt - - Interest paid on debt (after tax) _____ _____ Total financing flows (d + F) $4,064 $3,200 C – I = d + F

Reformulated Cash Flow Statement: General Electric In millions 2002 Cash flow from operations (C) $34,848 Cash investment (I) (61,227) Free cash flow (C – I) (26,379) Equity financing flows (d): Dividends and share repurchases $8,142 Share issues - 8,142 Debt financing flows (F): Net purchase of financial assets - Interest on financial assets (after tax) - Net issue of debt (40,603) Interest paid on debt (after tax) 6,082 Total financing flows (d + F) $(26,379)

Reformulated Balance Sheet

Balance Sheet Restated

Reformulated Balance Sheet: Nike Inc. (in millions of dollars) Operating assets (OA) 6,728 6,241 Financial obligations (FO) Operating liabilities (OL) 2,177 1,911 Financial assets (FA) (1,168) (581) Net financial obligations (NFO)(289) 302 Common equity (CSE) 4,840 4,028 Net operating assets 4,551 4,330 Total NFO + CSE 4,551 4,330 Balance sheet relations: NOA = OA – OL = 6,728 – 2,177 = 4,551 NFO = FO – FA = 879 – 1,168 = (289) (a net financial asset position) CSE = NOA – NFO = 4, = 4,840

Business Activities: All the Stocks & Flows Net operating assets are employed in operations to generate operating revenue (by selling goods and services to customers) and incur operating expenses (by buying inputs from suppliers). ∆ indicates changes. Key: F = net cash flow to debtholders and issuers d = net cash flow to shareholders C = cash flow from operations I = cash investment NFA = net financial assets NOA = net operating assets OR = operating revenue OE = operating expense OI = operating income NFI = net financial income

Reformulated Income Statement The difference between operating revenue and operating expense is called operating income: Net financial expense can be negative (net financial income)

Reformulated Income Statement: Nike Inc. In millions 2004 Operating income (OI) 1,035 Net financial expense (NFE) 16 Comprehensive income (CI)1,019

Business Activities and the Financial Statements This figure shows how reformulated income statements, balance sheets, and the cash flow statements report the operating and financing activities of a business, and how the stocks and flows are uncovered in the financial statements. Operating income increases net operating assets and net financial expense increases net financial obligations. Free cash flow is a “dividend” from the operating activities to the financial activities: free cash flow reduces net operating assets and also reduces net financial obligations. Net dividends to shareholders are paid out of net financial obligations.

Stocks & Flows: Operating and Financing Activities The change in NFO is given by The change in NOA is given by Operating income in the income statement flows to net operating assets in the balance sheet. Free cash flow reduces NOA and reduces NFO (increases NFA). If the firm has net financial assets rather than NFO, NFA t = NFA t-1 + (C t – I t ) + NFI t – d t

The Reformulated Statements: Nike Inc., 2004 Reformulated Balance Sheets Operating assets (OA) 6,728 6,241 Financial obligations (FO) Operating liabilities (OL) 2,177 1,911 Financial assets (FA) (1,168) (581) Net financial obligations (NFO)(289) 302 Common equity (CSE) 4,840 4,028 Net operating assets 4,551 4,330 Total NFO + CSE 4,551 4,330 Reformulated Income Statement, 2004 Operating income (OI) 1,035 Net financial expense (NFE) 16 Comprehensive income (CI) 1,019 Reformulated Cash Flow Statement, 2004 Free cash flow814 Equity financing flows: Net dividend to shareholders (d)207 Debt Financing flows: Net cash to debtholders/issuers (F)

Accounting Relations: Nike Inc., 2004 Balance sheet relations: NOA = OA – OL = 6,728 – 2,177 = 4,551 NFO = FO – FA = 879 – 1,168 = (289) (a net financial asset position) CSE = NOA – NFO = 4, = 4,840 Income statement relations: CI = OI – NFE = 1,035 – 16 = 1,019 Articulating relations between statements: The stocks and flows equation for equity: CSE 2004 = CSE CI 2004 – d 2004 = 4,028 +1,019 – 207 = 4,840 The free cash flow generation and disposition equations: C – I = OI – ΔNOA = 1,035 – 221 = 814 C – I = NFE – ΔNFO + d = 16 – (-591) = 814 The stocks and flows equation for operating activities: NOA 2004 = NOA OI 2004 – (C – I) 2004 = 4, , = 4,551 The stocks and flows equation for financing activities: NFO 2004 = NFO NFE 2004 – (C – I) d 2004 = = -289

Tying it Together: What Generates Value? From the balance sheet equation Given the way that NOA and NFO are calculated, which is the stocks and flows equation. For this to be true, however, accounting must be Clean Surplus. Free cash flow drops out in this calculation: Free cash flow (C - I) does not add value to shareholders. Free cash flow is a dividend from the operating activities to the financing activities What generates value is the profit from operating and financing activities.

Stocks & Flows Ratios: Business Profitability Separating operating and financing activities in the income statement identifies profit flows Comparison of these flows with their balance sheet base yields the corresponding rates of return: Return on Net Operating Assets Return on Net Financial Assets If there are NFO rather than NFA, net borrowing cost is given by Forecasting ROCE involves both the forecast of RNOA and RNFA (or NBC)